Private Debt: The Alternative Fixed Income Investment | CFA Level I Alternative Investments

In this quick discussion, we’ll dive into private debt, an alternative fixed income investment. We’ll focus on private debt and its four primary methods: direct lending, mezzanine debt, venture debt, and distressed debt.

Direct Lending

Direct lending involves making loans directly to a private entity. Like bonds, the borrower must make interest payments and repay the principal on a fixed schedule. These loans are typically senior, secured with collateral, and have covenants in place to protect the lender. However, unlike bonds, they cannot be publicly traded.

Private debt firms, like private equity firms, raise funds from investors seeking higher-yielding debt. These firms conduct due diligence on private entities before investing on behalf of investors.

Many private debt firms provide leveraged loans, which are loans that use borrowed capital. This allows firms to enhance the returns on their loan portfolios.

Mezzanine Debt

Mezzanine debt is subordinated debt financing provided to private entities, with a lower priority of claims than existing debt. Since it is junior-ranked and typically unsecured, these loans often have special features like conversion to shares rights or warrants to compensate for the added risk.

Venture Debt

Venture debt is lending to start-ups or early-stage firms that are not yet profitable. These firms usually lack substantial assets for collateral, so like mezzanine debt, venture debt often includes convertible features or warrants to compensate for higher risks. For example, the lender may be granted the right to buy the firm’s common stock under certain circumstances.

Distressed Debt

Distressed debt involves purchasing the debt of troubled companies, like those potentially or currently in default or bankruptcy proceedings. Distressed debt investors, sometimes called vulture investors, often take an active role in managing and reorganizing the company to help turn it around. The return on investment depends on the investor’s ability to restore the company to profitability.

Private Capital Firms

These four categories make up the major types of private debt investments. Firms that invest in private debt are known as private debt firms, while those investing in private equity are called private equity firms. However, private capital firms often invest in both the debt and equity of their portfolio companies.

As with most alternative investments, private debt provides diversification benefits to an investor’s overall portfolio. Private debt investments vary in risk and return, with senior private debt offering a steadier yield and moderate risk, while distressed debt carries the highest risk but potentially the highest return if the turnaround is successful. Overall, investing in private debt is riskier than investing in traditional bonds.

Investors should be aware of risks like illiquidity and heightened default risk when loans are extended to riskier entities. These risks are often compensated by higher yields than publicly traded bonds.